Potential Downside To Starbucks' Valuation

It has been a wonderful year for Starbucks Corporation (NASDAQ:SBUX). Shares of the company have advanced more than 40% since the start of the year, outperforming the broader indices. A series of strong results have upped the expectations of investors so much so that any blip in the coming quarters could bring the shares down. While it is true that brands such as Teavana and Evolution could become billion dollar brands in the long run, it would be unfair to factor in such assumptions until these brands actually start to make an impact on the company's income statement.

Here are a couple of reasons why shares of Starbucks could see some correction:

A) Sales Could Slow Down

In the latest quarter, Starbucks' same-store sales surged 8% in the Americas region. For a chain that has more than 19,000 stores globally, sustaining sales growth of this magnitude is highly improbable. In fact, there are already suggestions that same-store sales growth at Starbucks' stores might be slowing down. According to this Businessweek article, analysts at ITG Investment Research believe that sales at Starbucks' American stores could slow down to 6% in the first quarter of fiscal 2014 (i.e. Oct'13-Dec'13). The stock has already declined 5% since the article was first published on December 10.

Same-store sales, or comparable sales, is an important parameter to gauge a restaurant chain's performance since it excludes the effect of currency fluctuations and only includes the restaurants open for more than a year.

One must also keep in mind that sales growth in the last few quarters is also getting buoyed by expansion of the food menu under the La Boulange brand. By the end of the fourth quarter, La Boulange products were available at 3,300 Starbucks stores across the U.S. By the next fiscal year, the company plans to make these items available in 7,000 stores across the country. Once the favorable comparison of an expanded menu subsides, growing sales from that point onward would be tougher.

In addition, Starbucks reports only the sales growth of its company-owned stores, over which it has greater control. For licensed stores, the sales growth could be lower. Extending the growth figures of the company-owned stores to company-wide performance can result in overvaluation of the stock.

B) Margin Expansion Can Be Misleading

Starbucks' operating margins rose 150 basis points in the previous fiscal year. Furthermore, the company estimates the margins to rise another 150 to 200 basis points in the ongoing fiscal year. [1]

However, some of the margin expansion is occurring as a result of the rising proportion of licensed stores within the overall store count. Traditionally, Starbucks has had a greater proportion of company-owned stores. However, in the last few years, the company has shown an inclination toward opening more licensed stores. For example, as of September 29, 2013, 49.1% of Starbucks' stores were licensed as opposed to 48.0% as of September 30, 2012. [2]

Licensed stores can have margins three to four times those of the company-owned stores since the company doesn't have to incur operational expenses such as cost of raw materials, labor and occupancy costs. Therefore, as the proportion of licensed stores increases, margins will naturally rise. Starbucks does not reveal the margins of the company-operated stores and licensed stores separately so it is hard to accurately quantify the impact that the store openings are having on margins. Nonetheless, it would be fair to assume that only a portion of margin expansion is due to improvements in operational efficiency.

Low coffee prices are also benefiting overall company margins. Although the outlook for arabica coffee remains bearish, it would be unreasonable to assume that its price would remain subdued forever. Any improvement in the macro-economic environment of Europe, the biggest consumer of arabica, could spike up the prices of the coffee. This can have a significant impact on Starbucks' profitability since the company uses an awful lot of coffee.

Overall, fundamentals of the company look pretty solid. However, failure to recognize the possible caveats can cause investors to overestimate the growth potential of the company.

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